Lloyds TSB Financial Markets

Many assumptions about economic and financial market performance have been shattered in the 2 years since the global credit market crisis started. Not least amongst these assumptions was the view that ‘lean production’ methods – including manufacturers keeping stocks to a minimum and producing on demand to customer specification – would reduce the impact of the stock or inventory cycle on economic growth. But this economic downturn has, as always, been led by investment cut backs and falls in manufacturing output, driven by the inventory cycle. Chart a shows how sharp the fall in manufacturing output has been compared with the less pronounced reduction in the growth of volume retail sales, which has only just dropped into negative territory in annual terms.

A sharp drop in demand last year led to savage cuts in stock levels…
What appears to have happened is that a sudden, sharp and unexpected drop in demand last year, combined with a rapid rise in costs as energy prices rose to record highs and a tightening of credit conditions, led to a severe squeeze on company cash flows. The result was a savage reduction in stocks. In chart b, we show the percentage falls in the components of gdp since Q2 of last year - when gdp peaked. The biggest contributor to the fall in economic growth has been the change in inventories, which by itself accounted for over half of the 4.1% decline in gdp in this period. Moreover, chart c shows that the change in inventories as a share of gdp has been sharper than in the 1970s, 1980s or 1990s downturns.

...perhaps precisely because of ‘lean production’ which means firms respond quicker to changes in demand…
Why were the cuts in stock levels so harsh? For all of the talk that companies were carrying a lower level of stocks, the latest CBI industrial trends survey shows differently. The survey includes a question on whether reporting firms felt that present levels of stocks were more than adequate or less than adequate (to meet demand). The balance between these answers last year showed that, generally, manufacturing firms’ stock levels were much higher than the average since 1999. If so, then ‘lean production’ methods would produce a quick and severe response if demand disappointed expectations. To some extent, this is exactly what is shown in chart d: that the change in stocks as a share of gdp has been quicker for this stage of the downturn than in the last three recessions. This response would be sensible, and implies that once demand picks up, stocks could quickly add to economic growth as industrial output picks up as well. Some support for this notion can be found in chart e, which shows just how closely the stock cycle and production move together in the UK. The chart also highlights how severe the reaction to the reduction in demand has been from companies as they cut stocks and production, and the risks to growth if stocks are cut further.

…but despite recent reductions, stock levels are still high and if demand does not pick up then further cuts in production are possible
Unfortunately, analysis of chart d implies that inventory levels still remain high compared to the average since 1999 and so have the potential of falling further and hitting economic growth. Further, the close link between stocks and investment intentions shows that if stocks are cut further then investment spending could also be cut, see chart e. Such an outcome implies that economic recovery could be long and slow, and output could even fall back from current levels. This is because, as is apparent from the latest data point in chart d, investment intentions have improved but this is perhaps dependent on stock levels stabilising. However, for stock levels to stabilise, there needs to be an increase in final demand. If that does not materialise in the months ahead, possibly because rising unemployment hits consumer spending, there is room for stock levels to fall back and so investment to be cut once again, creating a vicious circle. The next few months will therefore be critical in deciding whether the current halt to the economic downturn, and some hopeful signs of a pick up, can become a sustained economic recovery.